Einhorn Solution: SEC won’t save you from next Bear Stearns

by Kurt Schulzke on June 23, 2008

The Bear Stearns collapse, like Enron and Worldcom before it, has prompted loud cries for more and better market regulation: Higher quality accounting standards! Better internal controls! More rigorous enforcement! But haven’t we been getting all this in an ever-rising spiral since 1934? The headline below captures the spirit of the times — New York Times, July 4, 1934, to be precise.

Next year will mark the 75th anniversary of the founding of the U.S. Securities and Exchange Commission. It was created as a political response to the market crash of 1929. Like politicians today, those back then had to be seen as “doing something” to “protect” investors. They thought they had the answer — more regulation. Or at least they wanted voters to believe this was the answer.

The excerpt below, quoting retired rum-runner and newly minted first-ever SEC chairman Joseph P. Kennedy, proclaims the dawn of a new market era, free of “manipulation” and “speculation,” after the very first meeting of the Securities and Exchange Commission.

It appears, today, childishly euphoric. But before we laugh we might ask ourselves, what will market pundits think of our own regulatory brilliance, 75 years on?

After 75 years, what has the SEC really accomplished? No matter how tightly the SEC and DOJ squeeze scapegoats after each successive market meltdown, the market melts again. Shouldn’t we be willing to consider the possibility that what needs to be changed isn’t the law or the SEC but the mindset of investors? Is it possible that more SEC actually makes market bubbles worse by lulling investors into a false sense of security?

In the June 30 issue of Time, Justin Fox describes David Einhorn’s information-based discipline of Allied Capital & Lehman Bros. But Fox seems to miss the central lesson of the story, that more regulation won’t prevent the next Bear Stearns:

After Lehman weathered the Bear scare, [David] Einhorn began to speak out. He said in April that the firm needed to cut its borrowing dramatically. Then in early May he began pointing out apparent gaps in its first-quarter earnings report. His comments, he later told me, amounted to saying, “Gee, there’s a naked emperor.”

For weeks, Lehman battled Einhorn’s assertions. Some of the Wall Street analysts who follow the firm dismissed him as a half-informed dabbler. Then Lehman disclosed that it had lost $2.8 billion in the second quarter. It raised $6 billion by selling new shares, addressing Einhorn’s concerns about overindebtedness. It removed its chief financial officer and chief operating officer. Chief executive Richard Fuld got on the company public-address system and declared, “Einhorn didn’t lose us $2.8 billion. We lost it.”

It’s possible that some of this would have happened without Einhorn’s badgering. But nobody else–not the SEC, not the Fed, not the analysts, not investors, not Lehman’s board–was putting public pressure on the firm’s executives to come clean. Some may have feared inciting a panic like the one at Bear Stearns. I asked Einhorn whether he worried about that. No, he said. “If you’re running a financial firm, you need to run it in such a way that you can survive a civil discussion.”

So far, Lehman has survived, although its stock price is down 70% from a year ago. Perhaps it’s time for a few more such civil discussions about how Wall Street does business.

Perhaps we should discuss how the regulators do business. Is the current model — stifling paperwork, ever higher financial penalties, and longer prison sentences — really the best? Is it reasonable to believe that more of the same — after 75 years of trying — is really going to stop the psychological phenomenon of market bubbles?

Mightn’t it be a better idea to tell market players to follow Einhorn’s example and look out for themselves a bit — to quit assuming that the nanny state can save the money they carelessly throw on the market? If you don’t understand a company’s revenue model — as it probably true of most hedge fund investors — why would you invest? Isn’t this what investors need to hear?

And what makes people think, after the SEC has failed so many times before, that giving it or some other government agency even more power is going to save their retirement nest eggs from the ravages of “manipulation” and “speculation” that Joseph P. Kennedy declared “over” in 1934?

If the government would just let market discipline work — punishing with losses those who invest foolishly — wouldn’t that eventually cure the bubbles and save more eggs? After 75 years, what do we really have to lose?